Commercial real estate lenders are typically in the business of taking credit risk, not interest rate risk. Accordingly, your CRE loan is likely to come with a floating rate, consisting of a spread — perhaps 2.5% — added to a floating benchmark that changes over time, such as SOFR. Entering into an interest rate swap can provide a higher certainty of future cash flows by locking in interest payments over an agreed-upon term. They’re essentially interest rate insurance.
Let’s outline a hypothetical rate swap and then dig into the definitions and structure:
Interest rate swaps are derivative contracts that supplement a loan agreement, but do not change it. The borrower’s obligation to pay their lender SOFR + 2.5% each month is unchanged. While the payments based on the 2.5% spread can be known in advance, the SOFR payments cannot. A swap hedges the variability of the SOFR payments with a pair of additional payments.
The payer entering into a swap contract will offer to pay their counterparty, the receiver, a fixed rate in exchange for receiving SOFR. Upon receiving SOFR each month, the borrower remits this payment to the lender along with the 2.5% spread, and pays the swap receiver the agreed upon fixed rate — in this case 3% — for a total fixed rate of 5.50%.
Because the swap does not affect the underlying loan, it is governed by separate documents. For a one-off transaction, a borrower may see simpler documentation through a long-form confirmation. This document will confirm the terms and conditions of the swap, including the principal amount, relevant dates, payment amounts and timing, and other business points of the transaction.
A more formal documentation process would include entering into an ISDA Master Agreement and Schedule, either before the swap is complete or after a long-form confirmation is received. The master agreement is an industry-standard document that provides legal and credit protections for swap (or other derivative) counterparties. Typically the Master Agreement is not changed, and any negotiations or transaction-specific information are incorporated into the accompanying Schedule. Consult with your legal counsel to determine which documentation method may be appropriate for your transaction.
The most important reason to enter into an interest rate swap is if your lender requires it. Still, this requirement can typically be negotiated, including the percent of the loan that must be covered by the swap, and whether or not the swap has last for the entire term of the loan. Other considerations for rate swaps primarily revolve around risk mitigation.
One of the fundamental principles of finance is that assets should match liabilities. The assets that generate cash flow are the leases in place. The liability of a floating rate loan is a series of unknown future interest payments. A hotel owner, who can reprice their leases every night, is much less susceptible to changes in interest rates than an office owner with 10-year leases and no Consumer Price Index or other inflation adjustment for rent increases.
Further matching assets to liabilities, the swap amount can reduce with the expected loan amortization, or remain flat over some or all of the term if there are interest-only payments on the loan. It can also be agreed upon and then begin at a future date by entering into a forward-starting swap. This way, the borrower is only paying for and getting the amount of protection they need when they need it.
What is expected debt service coverage on the loan? A loan at 1.6x DSCR can absorb a higher interest rate much more easily than a loan at 1.2x DSCR.
What are the plans for the asset? If you have a five-year loan, but expect to sell the asset in two or three years, entering into a five-year rate swap is likely unnecessary and may increase your interest rate risk by exposing you to interest rate fluctuations beyond your expected hold period.
The price of the fixed rate of an interest rate swap is determined by the market’s current expectation of future rates. These are indicated through a rate swap curve, similar to the Treasury yield curve. To value a swap, the forward expectations of rates at each payment date during the term of the swap are evaluated against the fixed rate paid to find a price where the net present value of both cash flows are the same. Remember how lenders are in the business of credit risk? Your receiver is also taking credit risk. Interest rate swaps trade over-the-counter, not through a clearinghouse. If a receiver enters into a swap with a borrower, they are expecting to receive years of fixed-rate swap payments.
With a fixed rate of SOFR = 3%, if SOFR falls from 3% to 1%, the receiver is entitled to what have become above-market interest rate payments. If the borrower defaults, the receiver suffers a loss by not collecting these payments. The receiver also has costs to enter into a swap, and presumably wants to make a profit on the trade. These costs and profits are recouped by adding a credit spread to the fair market value interest rate. Under Dodd-Frank, banks are required to disclose both the mid-market swap rate between the bid and ask prices, as well as the credit spread they are charging on top of that. The credit spread represents both the cost of execution for the receiver and the profit they are looking to charge on the trade. This transparency in an opaque market allows borrowers to get a better understanding of the cost of interest rate hedging.
Because swap providers do take some credit risk, swaps generally require some sort of security, such as liquid collateral, a cross-guarantee with the underlying asset, or a sponsor personal or entity guarantee. This requirement for security generally means that the lender, or a swap provider for the lender, is your only choice for a swap provider.
Providing stronger security, such as a lightly-levered asset, should result in a reduced credit spread. A more subtle reason to expect a reduced credit spread is a lower fixed rate, as the receiver is taking more risk expecting 5% payments each month than 1% payments.
The borrower does also assume some credit risk that rates rise and the bank or other swap provider will fail; this is a small but certainly non-zero chance (see: Lehman Brothers). Ideally the swap provider will have a high investment-grade credit rating; often smaller local or regional banks will outsource rate swaps for their borrowers to a major national bank.
Once you enter into a swap, it will have a market value based on movements in interest rates. If rates rise, your swap will become valuable. If rates fall, it will become costly. This value changes every day in a process called mark-to-market which accounts for the fair market value of the swap. A borrower may receive a report indicating the value of the swap monthly or quarterly, though you can ask for an indicative value at any time.
Because of the credit charge, you would expect the value of the swap to be negative initially. As time goes on, it may fluctuate above and below $0. The swap can be paid off or cashed in at any time through an early termination (unwind) at the borrower’s option.
The swap is independent from the underlying loan, so if the loan is refinanced, the borrower will usually have to take action with the swap. Unwinding the swap is generally the easiest method, though this could expose the borrower to a large cash payment that may not be desirable. Another option is to replace the existing counterparty with a new one through a process called novation.
Before entering into an interest rate swap, speak with a trusted advisor or contact one of many independent derivatives advisors. It’s crucial to understand ahead of time all of the business terms and responsibilities you will be agreeing to and ensure that the swap fits your particular requirements. Once a swap is in place, you may sleep better at night knowing a large source of volatility has essentially been eliminated, though all insurance comes with a cost.
But don’t set it and forget it! It’s important to monitor the value of your swap over time so there are no surprises if you need to or want to unwind it someday.
Eric Rodawig is the Finance Director at City+Ventures in Omaha, Nebraska, where he leads debt origination and real estate acquisitions for the dynamic investment & development company. He has originated over $2 billion of loans throughout his career and led all aspects of both real estate and private equity acquisitions and dispositions for multiple family offices. He began his career with HSBC USA’s Corporate Bank in Washington, DC, and is a proud graduate of Georgetown University with an honors degree in Economics.
